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Qualified Small Business Stock: An Opportunity for Tech Startups

By Brad McGuire, CPA, and Jim Mal­czewski, CPA, Appleton, Wis.

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Tax Section

Editor: Alan Wong, CPA

Gains
& Losses

Technology companies, in
particular biotech, face large hurdles in raising
capital to sustain operations until they have a
viable product in a marketplace. As a result,
their capitalization schedules are unlike those of
other types of businesses where capital is
provided once at startup and operations are funded
from sales or services that are made or delivered
soon after organization. The existence of
convertible debt, incentive stock options,
warrants, and preferred stock, along with the need
for additional capital, creates opportunities to
issue additional qualified small business stock
(QSBS) in 2013. The benefit of the QSBS gain
exclusion is enhanced with the increase in capital
gain rates that went into effect in 2013.

QSBS issued after Aug. 10, 1993, and before
Feb. 18, 2009, was eligible for a 50% exclusion
from capital gains; however, the balance was
subject to the 28% capital gain rate. The
alternative minimum tax (AMT) also came into play
to further reduce the small benefit derived from
the exclusion. This limited benefit also reduced
the effort that practitioners put into planning
around Sec. 1202. That changed with the
enactment of the American Recovery and
Reinvestment Act of 2009 (ARRA), P.L. 111-5.
ARRA increased the exclusion rate from 50% to
75%, but retained the 28% rate on the remainder,
as well as the alternative minimum taxable
income adjustment. The 75% exclusion is
effective for stock acquired from Feb. 18, 2009,
through Sept. 27, 2010. This gave practitioners
more incentive to begin exploring opportunities,
but the exclusion was still limited, still had
AMT implications, and required a stock sale to
take advantage of the tax benefit.

On Sept. 28, 2010, the Small Business Jobs Act
of 2010, P.L. 111-240, increased the exclusion to
100% for both regular and AMT purposes but only
for stock issued prior to Dec. 31, 2010. The 100%
exclusion was then extended on Dec. 17, 2010, by
the Tax Relief, Unemployment Insurance
Reauthorization, and Job Creation Act of 2010,
P.L. 111-312, through Dec. 31, 2011. The 100%
exclusion provision expired on Dec. 31, 2011, but
it was restored retroactively by the American
Taxpayer Relief Act of 2012, P.L. 112-240, which
was signed into law on Jan. 2, 2013. The extension
is temporary through Dec. 31, 2013.

The
history of this provision has not allowed much
time for tax practitioners to maximize its use.
With the provision set to expire again on Dec. 31,
2013, now is the time to work with clients to
attempt to maximize the amount of future gains
that could be excluded entirely from federal tax.
Unless the 100% exclusion is extended, QSBS gain
on stock issued in 2014 and after will revert to a
50% exclusion, and a portion of the excluded gain
will be subject to AMT. Due to the various
effective dates and exclusion percentages, it is
imperative to track original issue dates of the
stock, as well as to understand which stock
transactions constitute a new issue. Issuers and
investors of QSBS must document the original issue
dates and qualification as QSBS at the time of
original issue.

The exclusion for QSBS gain described in
Sec. 1202 is not unlimited and is computed at
the shareholder level. In general, the amount of
QSBS gain that can be excluded from income is
the greater
of$10 million or 10 times the
aggregate adjusted basis of the QSBS issued by
the corporation and disposed of by the taxpayer
during the tax year. Eligible shareholders
include individuals and passthrough entities
only; corporate shareholders are not eligible.
The $10 million limit is a lifetime aggregate
amount that must be tracked per issuer by the
taxpayer. Adjusted basis is determined without
regard to any addition to basis after the date
on which the stock was originally issued.
Eligible gain means any gain from the sale or
exchange of QSBS that is held for more than five
years.

QSBS
Defined

The definition of QSBS seems
relatively simple at first glance, but it becomes
more complicated upon further reading. To qualify
as QSBS, the corporation must meet the definition
at the time the stock is originally issued to the
taxpayer reporting the gain. QSBS includes any
stock in a C corporation received in exchange for
either money or property or as compensation for
services provided to the corporation.

In
general, QSBS includes stock in a domestic C
corporation if the aggregate gross assets of that
corporation did not exceed $50 million either
before or immediately after the issuance of the
stock. Aggregate gross assets means the amount of
cash and the aggregate adjusted basis of other
property held by the corporation. In the case of
appreciated contributed property, the adjusted
basis of the property will be determined as if the
property were contributed at its fair market
value. The $50 million limit includes all
corporations within a parent-subsidiary controlled
group. The ownership threshold for a
parent-subsidiary controlled group is 50%
ownership of the subsidiary for this purpose.

Care must be taken to review and assure that
the stock not only met the QSBS definition at the
time of issue but also to document that the stock
continued to meet certain requirements that must
be maintained over the holding period. There is
not much guidance in the way of regulations or
case law, due to the relatively few taxpayers who
used the provision before 2009 and the fact that
no QSBS eligible for 100% gain has yet been
sold.

An additional requirement is that the
corporation must meet an active business
requirement for “substantially all” of the
taxpayer’s holding period for the stock. Active
business is defined as using at least 80% of the
assets by value of the corporation in the active
conduct of one or more qualified trades or
businesses. Special rules apply for startup
activities, research and experimental expenditures
under Sec. 174, or activities with respect to
in-house research expenses described in Sec. 41.
Assets used in these categories are deemed to be
used in an active trade or business. The Code also
allows for assets held for “reasonably required
working capital needs.” Other key areas to
consider are limits on real estate holdings,
nonsubsidiary stock holdings, and computer
software royalties. These requirements must be
monitored over the taxpayer’s holding period, not
simply at the time of stock issuance.

The
definition of qualified trade or business
specifically excludes professional services such
as health care, law, engineering, architecture,
accounting, actuarial sciences, performing arts,
consulting, athletics, financial services,
brokerage services, or any other trade where the
principal asset of the trade is the reputation or
skill of one or more of its employees. Also
excluded are banking, insurance, financing,
leasing, investing, or similar businesses; farming
activities; and businesses involving the
production or extraction of products eligible to
receive a depletion deduction. Additionally,
businesses operating a hotel, motel, restaurant,
or similar business are statutorily excluded. Care
must be taken to determine that the corporation
issuing stock purported to be QSBS is not involved
in any of the prohibited trades. It bears
repeating that this qualification is not only
important at the time of issuance but also during
the entire holding period.

Rollovers

Another opportunity
for holders of QSBS is provided by Sec. 1045.
Secs. 1045 and 1202 define QSBS in the same
manner, which will be discussed in the coming
paragraphs. This option is available to
investors in QSBS that have held the stock
for at least six months. Sec. 1045 allows a holder
of QSBS to roll over gain into replacement QSBS.
The taxpayer must invest in the replacement QSBS
within 60 days of the sale of the QSBS. The
taxpayer will only recognize gain to the extent
that the amount realized on the sale exceeds the
cost of any QSBS purchased during the replacement
period (less any portion of that cost previously
taken into account under Sec. 1045). The amount of
the deferred gain reduces the basis in the
replacement QSBS, so any gain not recognized
currently is deferred, not excluded.

There
is no specific language in either Sec. 1202 or
1045 that indicates the two sections are mutually
exclusive. Therefore, it would be reasonable to
conclude that a taxpayer who exceeds the dollar
limits of Sec. 1202 could use Sec. 1045 to defer
the excess gain. Obviously, the QSBS gain would
have to meet the longer five-year holding period
for Sec. 1202 exclusion.

Planning

Since the 100%
exclusion is set to expire on Dec. 31, 2013,
startup tech companies and other qualifying C
corporations should look at their current and
planned capital transactions for opportunities to
increase the amount of stock issued that would
qualify for the 100% exclusion. This means
creating newly issued stock in 2013. By issuing
stock in 2013, a corporation may be able to
improve the position of its shareholders that
originally received shares prior to 2009. Having
stock that is eligible for the 100% exclusion may
also become a negotiating tool for the exit of the
founders.

However, it does not make sense to
ignore the tax consequences of transactions, in
the interest of issuing new QSBS. For instance,
exercising stock options would be a way to get
additional QSBS eligible for the 100% exclusion.
Consideration must be given to compare paying tax
currently at ordinary income tax rates versus the
potential for a zero tax stock sale at least five
years in the future.

This may make sense,
or it may not. However, if a plan is already in
place to exercise shares, if they are about to
expire soon after Dec. 31, 2013, or if the strike
price is near the fair market value price and
current taxes are minimal, the exercise of the
option in 2013 as opposed to 2014 is worth
considering. Convertible debt is another area that
may yield results by accelerating conversion
during 2013. Practitioners need to be wary of
triggering cancellation-of-debt income from
changing terms of outstanding debt as well as
triggering interest income on the conversion,
whether or not the interest is paid in cash or in
additional stock.

This is also a
transaction where taxable income will be
recognized, yet it may be beneficial to do so in
2013 rather than 2014. Shareholders receiving
restricted stock will have another reason to
consider a Sec. 83(b) election to lock the share
issue date in 2013. Noncompensatory avenues to
increase shares issued in 2013 could be considered
as well. Such options could involve the
declaration of dividends with a dividend
reinvestment plan or, more simply, the issuance of
new shares for cash or property.

In
summary, practitioners should proactively work
with C corporation clients and their attorneys to
consider ways to increase the number of QSBS
shares that are eligible for the 100% exclusion.
This provision in Sec. 1202, along with the
rollover provision of Sec. 1045, could provide a
very tax-favorable exit strategy. Now is the time
to assure this option is available and maximized.
The clock is ticking, again, on this provision,
which reverts to a 50% exclusion for stock issued
after Dec. 31, 2013, greatly limiting the planning
value. Reactive tax planning involves answering
clients’ questions in five years when they are
considering a sale; proactive tax planning
involves planning now to maximize the potential
benefit of QSBS in the years ahead when an exit is
being considered.

EditorNotes

Alan Wong is a senior manager–tax with Baker
Tilly Virchow Krause LLP, in New York City.

For additional information about these items,
contact Mr. Wong at 212-792-4986, ext. 986, or awong@bakertilly.com.

Unless otherwise
noted, contributors are members of or associated
with Baker Tilly Virchow Krause LLP.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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